Federal Reserve Stress Test failed by 5 major banks

Early last Thursday, March 27, the Federal Reserve, the entity charged with setting U.S. monetary policy and with regulating some banking activities, announced the results of its 2013 stress tests. Of the 30 institutions that were examined, five banks did not pass. Most alarming among the names of banks failing the exam were Citigroup, Inc. and HSBC North American Holdings Inc., with Citigroup reigning as one of the largest banks in America and as the 17th largest company in the world, according to Forbes.

These stress tests have taken place every year since 2009, when they were implemented to combat the systemic risk issues of the “too big to fail” (TBTF) banking institutions, such as JP Morgan, Bank of America, Cleveland-based Keycorp, Pittsburgh-based PNC Financial Services Group and 26 other institutions of similar size.

These yearly evaluations, formally known as “Comprehensive Capital Analysis and Review,” (or CCAR) are incredibly important, as they assess the TBTF institution’s relative ability to demonstrate adequate capital reserves and comprehensive capital planning, with an emphasis on planning for the possibility of an economic downturn, such as the housing and banking crisis of 2008.

These tests evaluate TBTF institutions’ ability to continue their main courses of business in the event of a significant economic downturn. In laymen’s terms: can they continue to lend money to businesses and households, while servicing their existing debt obligations?

Contrary to what its failure might lead investors to believe, Citigroup is actually one of the best capitalized of the TBTF banks, according to Bloomberg.com. The reason for its failure was qualitatively based.

According to Forbes.com, the Federal Reserve objected to Citigroup’s planning scenarios for its international divisions, failing to accurately forecast possible downturns in regions in which it has significant exposure to, such as Asia. The report states that “practices with specific deficiencies included Citigroup’s ability to project revenue and losses under a stressful scenario for material parts of the firm’s global operations, and its ability to develop scenarios for its internal stress testing that adequately reflect and stress its full range of business activities and exposures.”

The CCAR also evaluates the viability of banks plans to return capital to investors, in the form of share-buyback programs and dividends. In the case of Citigroup, they planned to quintuple quarterly dividends (to 5 cents) and institute a $6.4 billion share-buyback program. These proposals were denied as a result of Citigroup’s failure.

Investors shouldn’t be spooked by this turn of events; Citigroup remains one of the best capitalized banks with solid earnings and positive future prospects. Of the major banks (excluding Zion Bancorporation) that failed the CCAR on March 26, all of them remain in good financial standing. The Federal Reserve failed them for “qualitative reasons.”

Imagine turning in a paper that your professor won’t accept because the font isn’t in Times New Roman, 12 point font. It’s the same kind of thing.

Editor’s Note: Information from Bloomberg.com, the Federal Reserve, and Forbes.com was used in this article.